JPMorgan Pays for Shorting Madoff Without Telling Anyone
When I started working at an investment bank there was a series of compliance videos that one played in a corner of one's computer while doing other work. Nonetheless, the money-laundering one seems to have stuck with me: I still remember the basic plot, in which someone asks a banker questions about how he ignored red flags in a client's account-opening documents, and then at the end the camera moves back and you see that the banker is in prison. Prison for letting someone else launder money! Really makes you think, I guess, primarily about the realism of the compliance videos.
But maybe not, since JPMorgan is going to prison for missing some red flags while working as Bernie Madoff's primary bank. Hahaha no that's impossible, but it is forfeiting $1.7 billion [update: plus a separate $350 million fine and $543 million in private lawsuit settlements], which is really quite a lot of money,1 to settle money-laundering and so forth charges relating to the fact that it sort of noticed that Madoff was a Ponzi scheme and then didn't do anything about it.
The documents, including particularly the Statement of Facts that JPMorgan has admitted to, are pretty interesting. One obvious reaction is that it's a bit hard on JPMorgan that they're paying $1.7 billion for not catching Bernie Madoff even though they were his bank. The government regulators, led by the Securities and Exchange Commission, also didn't catch Bernie Madoff, even though they were his regulators and that was literally their job. And while yes JPMorgan ignored some red flags, so did the SEC. Like, the many many credible letters they got to the effect of "Bernie Madoff is a big ol' Ponzi scheme."2 Should the SEC be paying an even bigger penalty than $1.7 billion?
Of course, the regulators were missing some evidence, such as the Suspicious Activity Report that JPMorgan should have filed with the Financial Crimes Enforcement Network (FinCEN) but didn't. But hold on wait what:
In or about 1996, personnel from Madoff Bank 2 investigated the round-trip transactions between Madoff and the Private Bank Client. As a result of that investigation, which included meeting with representatives of Madoff Securities, Madoff Bank 2 concluded that there was no legitimate business purpose for these transactions, which appeared to be a "check kiting" scheme, and terminated its banking relationship with Madoff Securities. ... In addition, although unknown to JPMC at the time, Madoff Bank 2 filed a SAR in or about 1996 identifying both Madoff Securities and the Private Bank Client as being involved in suspicious transactions at Madoff Bank 2 and JPMC "for which there was no apparent business purpose."
That's paragraph 25 of the Statement of Facts (emphasis added). The details are a little boring,3 but the point is that in the mid-'90s FinCEN got a Suspicious Activity Report detailing some of the naughty business that Madoff was doing at JPMorgan -- and that JPMorgan is now accused of covering up -- and, y'know, nothing happened. "If only JPMorgan had filed a Suspicious Activity Report, we woulda caught Madoff!," say the regulators, extremely counterfactually.
Not, though, to excuse JPMorgan too much. This is a story full of terrible ineptitude. It starts with the relationship banker who oversaw what the Feds call the "703 Account," which was "the bank account that received and remitted, through a linked disbursement account, the overwhelming majority of funds that Madoff's victims 'invested' with Madoff Securities," and which regularly contained multiple billions of dollars. And here is what the JPMorgan banker responsible for it thought it was (paragraph 20 of the Statement of Facts):
Madoff Banker 1 believed that the 703 Account was primarily a Madoff Securities broker-dealer operating account, used to pay for rent and other routine expenses. Madoff Banker 1 also believed that the average balance in Madoff Securities' demand deposit account was "probably [in the] tens of millions." He did not understand that the 703 Account was, in fact, the account used by Madoff's investment advisory business, and achieved balances of well more than $1 billion beginning in approximately 2005, and up to approximately $5.6 billion by 2008.
Oops! I like this guy. I feel like there are a lot of bankers who want to overstate the value of their client relationships. Madoff Banker 1 is like the one banker on earth who underestimated his client's business by a factor of 100 or so. "Boss, I've made the firm thousands of dollars this year," he probably said, "and I deserve a bonus of at least $200."
But some bits of JPMorgan come out of this settlement looking pretty good. Like the part that shorted Madoff! Did you know that you could short Madoff? Well, you couldn't, but JPMorgan could. The people at JPMorgan who ferreted out -- or, at least, assumed out -- Madoff's fraud were mainly working on or with the equity exotics desk, which was selling structured notes linked to the returns on Madoff feeder funds.
Oversimplifying slightly, equity exotics worked as a Madoff feeder fund itself: It sold clients notes linked to Madoff's performance, and hedged those notes by investing its own money into Madoff feeder funds. It did this in $105 million-ish size in June 2007, and then sought permission to increase its exposure because lots more clients wanted to invest in Madoff-linked notes. That triggered JPMorgan's internal investigation, in which smart people concluded things like "the main risk this trade poses is systemic fraud risk at the BLM [i.e., Bernard L. Madoff] level," and in which the head of due diligence joked that they should visit Madoff's accountant's office "to make sure it was not a 'car wash.' "4 Still, while JPMorgan was investigating, its Madoff exposure got as high as $379 million, but ultimately dropped to $81 million after it concluded the investigation and decided to walk away slowly with its hands in its pockets while whistling a jaunty tune.
Meanwhile, JPMorgan was unwinding its client-facing structured note trades, but it put somewhat less urgency on that project than it did on getting its own money out of Madoff. Paragraph 68:
Although JPMC sharply reduced its hedge position in Madoff feeder funds, it was exposed to substantial risk in the event that Madoff Securities continued to perform successfully because it had not been able to unwind or otherwise cancel an equivalent value of JPMC-issued notes linked to the performance of the Madoff feeder funds.
Hahaha that's "they were short millions of dollars of Madoff." In hindsight the right trade was just to write lots more structured notes on Madoff, sell them to clients, not hedge them, and wait for the whole thing to collapse and your obligations to go to zero. I guess that would be too cute though, and JPMorgan does seem to have made semi-heroic efforts to unwind the trades and save its equity exotics clients.5
But it left Madoff's other clients to be hosed: While the equity exotics guys in England ultimately reported their suspicions to the U.K.'s Serious Organized Crime Agency, no one at JPMorgan ever filed a Suspicious Activity Report with the U.S. FinCEN. Nor does anyone from the exotics side seem to have gotten in touch with hapless Madoff Banker 1, who thought he was overseeing a smallish miscellaneous-expenses account rather than the main instrument of Madoff's Ponzi scheme.
Part of that is understandable? I mean, the part where they filed a suspicious activity report in the U.K. and not the U.S. is just plain dumb, I have no excuse for that, it's just a lazy failure of communication. But the lack of coordination between the equity exotics traders and the custodian bankers makes a bit more sense, even if the lack of coordination between their respective compliance supervisors is harder to understand. In October 2008, an equity exotics analyst wrote a memo summarizing his due diligence, and his suspicions, about Madoff, concluding that "we seem to be relying on Madoff's integrity ... and the quality of the due diligence work (initial and ongoing) done by the custodians." The custodians were at JPMorgan!
But he never called them. Because that's not how it's done. Equity exotics sat in London and was a public-side trading desk. Calling up Madoff's custodial banker at JPMorgan would be unsporting, and probably somehow illegal. You can't just use your position as Madoff's custodial banker to help your business trading derivatives on Madoff. The nice thing here would have been to use the insights developed by the Madoff-derivative traders to help out the custodial bankers, but I guess the arrow doesn't run that way either.
What should you conclude about JPMorgan here? "JPMorgan is too big to manage" is sort of a lame thing to think and I don't think that the failures of coordination really get to that. Equity exotics actually did a good job staying away from Madoff (and shorting him). Custody banking did a garbage job of shutting him down, but that's probably because any custody bank would have done a garbage job of shutting him down. The failure was not that JPMorgan was dumb, but that its smarts in one business didn't end up helping where they needed to.
JPMorgan is not so much a single firm moving through the world with an integrated business strategy as it is a giant bundle of loosely sorted independent bits that together provide every conceivable financial service.6 The benefits are mainly in cross-selling opportunities: You never know when your checking account clients might need some equity exotics, so you can make some extra money (and keep the client happy with a one-stop shopping experience) by just offering everything.
If you think of JPMorgan's businesses as operating more or less independently, but occasionally making each other money by cross-selling, then this mess makes more sense. A London investment bank that considered and rejected a derivative-linked investment in Madoff would have no obligations to report its suspicions to U.S. regulators. A boring custody bank that ran Madoff's checking accounts but had no derivatives traders to get suspicious about him also probably wouldn't be in trouble for missing the Madoff red flags. Combine the two businesses and the same behavior gets you in trouble. In that sense, JPMorgan's $1.7 billion forfeiture here looks a bit like a tax on bigness and integration: You can grow huge, offer a loosely integrated set of every conceivable financial product, and bask in the cross-selling opportunities, but every now and then it'll cost you a couple of billion dollars. So far that trade-off still seems to be worth it for JPMorgan.
1 Though also an arbitrary one. Here, from the forfeiture complaint:
The $1.7 billion that JPMC has agreed to forfeit to the United States pursuant to the Deferred Prosecution Agreement represents a portion of the funds leaving the Madoff Securities accounts at JPMC from October 29, 2008 (i.e., the date of JPMC's report to SOCA) until Madoff's arrest on December 11, 2008 ...
So at the time JPMorgan filed a report with the U.K.'s Serious Organized Crime Agency saying that it thought Madoff was a fraud, there were several billion dollars in Madoff's JPMorgan bank account. (Not totally clear how much, but there was $5.6 billion in August 2008 and $234 million in December 2008.) That money vanished on JPMorgan's watch. And now JPMorgan is paying back "a portion" of it.
2 I guess Harry Markopolos is the obvious citation here. And of course there were those at JPMorgan -- like its global head of equities -- who didn't believe that Madoff could be a Ponzi because he was "regulated by the SEC, NYSE, NASD etc." I guess everyone figured catching Madoff was someone else's job.
3 Madoff and a big private banking client at JPMorgan (actually Chemical Bank, a predecessor) got themselves into a little check-kiting scheme, where Madoff would write checks (on his account at "Madoff Bank 2," i.e. not JPMorgan) to the private bank client, then transfer cash from his JPMorgan account to that account, and then the private client would transfer cash from his account to Madoff's JPMorgan account, with the purpose being basically to give Madoff the interest on the float for some reason.
4 Also a little fun is that the reason JPMorgan couldn't do due diligence directly on Madoff was that Madoff "did not approve of the Madoff-linked derivative products and would not allow JPMC to conduct due diligence on his fund directly." Even Madoff didn't like Madoff-linked derivatives. In hindsight Madoff-linked derivatives sound terrible.
Also, in other, dumber, news, I liked that one equity exotics employee who was tasked with doing due diligence on Madoff couldn't find any way to replicate Madoff's investing results, but "e-mailed a colleague that he did 'take comfort from the fact' that two separate Madoff feeder funds were reporting close to the same returns for the period." Consistently reporting your own fraudulent results seems like a pretty minimal standard for due diligence.
5 By the way there's great stuff here on JPMorgan's efforts to unwind those notes. Check out paragraph 65 of the Statement of Facts, in which "JPMC sought, with the assistance of legal counsel, to cancel or otherwise unwind certain of the structured products" by "invoking a provision of the derivatives contract that enabled it to de-link the notes from the performance of the Madoff feeder funds if JPMC could not obtain satisfactory information about its investment." That's some amazing one-way optionality for JPMorgan there! "We'll sell you a thing that gives you upside in Madoff's funds, unless we're too confused, in which case, never mind." Clients were understandably (though wrongly!) annoyed, including one distributor of the structured notes who (in paragraph 61) "expressed displeasure about JPMC's proposed action and referenced having 'Colombian friends who cause havoc . . . when they get angry. . . .'" That threat caused JPMorgan to file another, more salacious, suspicious activity report with the U.K. Serious Organized Crime Agency.
6 Except prop trading hahahahahahaha.